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Overt Monetary Financing (OMF) and Crisis Management

The Year Ahead 2018

The world’s leading thinkers and policymakers examine what’s come apart in the past year, and anticipate what will define the year ahead.

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In a recent lecture at the Cass Business School, Lord Adair Turner suggested that the economies of many advanced countries are in such a “mess” that policy makers should be prepared to break a taboo. They should consider carefully the pros and cons of increased fiscal deficits, explicitly and permanently financed by an increase in base money issued by central banks. In response, a lively debate on this issue has begun, which is useful for two reasons. First, it widens the scope of possible tools to manage the ongoing crisis. Second, it reminds us that there is a current crisis that needs managing.

This may seem an odd thing to say at this juncture, but many of the policies being followed currently seem directed much more to preventing the next crisis than curing the current one. Significant reductions in fiscal deficits and sharp increases in bank capital ratios are cases in point. While they clearly have desirable medium term implications, their near term effects on demand growth are unwelcome. Conversely, ultra easy monetary policy might have desirable short run effects on demand but undesirable medium term implications. In any event, it seems decidedly odd to be driving the economic car with one foot on the brake and one foot on the pedal. We need more clarity about the objectives of these diverse policies and whether they are or can be made mutually consistent.

One aspect of this broader confusion between crisis management and crisis prevention is manifest in references to the Chicago Plan to support OMF. It is true that members of the Chicago School (Milton Friedman and Henry Simons), along with Irving Fisher, suggested back in the 1930’s that government deficits should be financed directly by fiat money. Nevertheless, the motivation and recommendations in the Chicago plan were actually quite different from those currently supporting OMF. The objective of the Chicago Plan was to prevent crises not to manage them.

Dating from the time of Wicksell (and perhaps before), the insight that banks create money in the process of making loans has become more widely accepted. In effect, given a fractional reserve banking system, banks simply write up both sides of their balance sheet. This fact is what fundamentally distinguishes a monetary economy from a barter economy, and leads to the possibility (indeed, Minsky would have said, the inevitability) that excessive credit creation will lead to cycles of “boom and bust”. Both Hayek and Keynes recognized this fact.

Against this background, the Chicago plan aimed to prevent crises by taking away the capacity of private banks to create money. Narrow banking was the very core of their proposal. In contrast, OMF has to do with crisis management, with getting out of the current “mess”. Moreover, absent any suggestion of getting rid of fractional reserve banking, the increase in base money associated with OMF would have the potential to generate still more private sector debt and still more leverage. This is unfortunate since excessive debt and leverage seems to have played a big role in creating our current problems in the first place.

Another way to characterize the difference in interpretation is that Simons and Friedman were proposing a regime change, whereas those supporting OMF are proposing a policy change. Had the proposed regime change been in place, an economic downturn requiring an expanded government deficit and a rising monetary base would have been preceded by an expansionary period of declining deficits and a falling monetary base. Since this was clearly not the case in recent years, I suggest that both Simons and Friedman would have seen more risks than promise in OMF at this juncture. It is also important to note that, under the Chicago Plan, the increase in base money in bad times would have been temporary and not permanent.

In fact, if I had to emphasize just one aspect of the Chicago plan it would not be linking government finance to the provision of inside money. Rather, it would be the insight that financial structure matters for the performance of the financial system and the economy it supports. The current system we have today allows the utility functions of banks (payments, deposit taking and the provision of loans to industry) to be threatened by activities that have a real casino quality about them. Four years after the crisis, we still have banks that are too big to fail, and a shadow banking system that is so opaque there is no agreement on either how to define it or measure it. Nor is there any agreement on how these problems might be minimized

This state of affairs should change in a fundamental way. However, given the magnitude of the public sector subsidies currently given to support the current system (e.g. , lower borrowing costs for firms deemed “too big to fail”), it is not surprising that financial industry representatives are lobbying hard to keep things essentially the way they are. This can only be dealt with by polices that might have to be even more radical than the adoption of OMF

Crisis Management: What is the problem? Could OMF be part of the solution?

What is the problem we currently face? It is the need for the private sector (both borrowers and lenders) in the advanced market economies to delever after a long credit boom supported and accentuated by twenty years or more of Greenspan “puts” and other safety net measures. We are at the end of what George Soros has called the “supercycle”, characterized by rampant financial speculation, unprofitable real investments and a host of other “imbalances”. Further, the problems posed by the need for deleveraging have been accentuated by the fact that the problem does not just affect a few countries but almost every large country in the global economy. As a result, and unlike most previous debt crises, individual countries cannot count on growing out of their debt problems on the backs of the improving fortunes of their neighbors.

How did this problem become global? When the Advanced Market Economies (AME’s) repeatedly and asymmetrically relied on monetary and credit expansion to resist economic downturns, their exchange rates should have fallen. However, the Emerging market Economies (EME’s), not least China, resisted this through outright intervention in foreign exchange markets and easier monetary policies than they would otherwise have followed. In short, the problems of the AME’s were effectively imported by the EME’s, while liquidity created in the EME’s worsened the problems of the AME’s. Thus, we now have a problem of excessive leverage and dangerous “imbalances” almost everywhere. The fact that our International Monetary System (or rather, non-system) allowed this outcome, indicates that we need to go back to these “systemic” questions with great urgency.

Having identified the problem, the next question is whether still another round of stimulative macroeconomic policies might be part of the solution. This is certainly conceivable though the case is by no means watertight. There is more to an economy than just real side demand. First, demand stimulus can get in the way of deleveraging, and the McKinsey Institute reminds us that this process has hardly begun. As of 2011, only three countries (the US, South Korea and Australia) had total debt ratios (public and private) that were lower than they had been on the eve of the crisis. Second, credit related crises often result in distortions on the supply side of the economy which reduce the level of potential. This raises the risk of inflationary pressures reemerging in the wake of still more demand stimulus. The UK could well be a portent of things to come in other countries. Finally, most countries have already done a massive degree of fiscal and monetary easing, and it has not produced “strong, sustainable and balanced growth” as the G20 would like. Would “still more of the same” do any better?

A crucial, further question is whether “still more of the same” might introduce new risks that might actually be greater than the risks associated with just putting up with somewhat slower growth for a while. Or to put it another way, the economy is a highly complex system in which multiple equilibria seem possible, and whose functioning we hardly understand. In pursuit of what Hayek called “the fatal conceit”, the assumption that fallible policymakers can fix all our problems, is there not a danger that we will push the economy still further beyond what Axel Leijonhufvud calls the “corridor of stability”?

I generally agree with those who point out the downsides of monetary policy operating all on its own. First, it might not work. Keynes himself came to this conclusion as he progressed from the Treatise to the General Theory. Second, it might have “harmful adverse consequences”. I have written extensively on this, and I believe that these risks continue to be underestimated by central banks worldwide. At the moment, my greatest concern is that monetary policies are distorting enormously the functioning of financial markets. The situation today looks to me like 2007 all over again, with a sharp fall in bond and equity prices being top of my list of worries. This could have important implications for financial stability.

I also agree with the concerns raised by many about relying further on traditional, expansionary fiscal policy. If financed with more debt, as is currently the case, sovereign rates in some countries could rise in a discomforting way and perhaps even in an unsustainable way. In this regard, my principal concern is that we have no criteria to help us understand when this might happen. Two particular cases make this clear. On the one hand, I find convincing the argument of Paul De Grauwe that a number of peripheral European sovereigns have been victims of a self fulfilling market attack that could not be justified by initial (or even projected) sovereign debt levels. On the other hand, a very recent OECD study suggests that Japan, the UK and the US will face the greatest problems in stabilizing their government debt ratios. Implicitly, the policy advice is that they should address this problem urgently. Yet, these are the countries that have among the lowest sovereign borrowing costs in the OECD area. This absence of criteria is a serious impediment to giving advice to countries about the appropriateness of their fiscal stance.

Given the shortcomings of both monetary and fiscal policy on their own, is it possible that a combination of these measures, specifically OMF, might prove better able to generate “strong, balanced and sustainable growth? ”By way of analogy, it is like saying “Soup and sodium – not good. Soup and chlorine - also not good. But, soup and sodium chloride – very tasty”. Frankly, I am skeptical, although likely not as skeptical as Jens Weidman, and would like to raise a few questions just to stimulate discussion.

What precisely is the difference between OMF and what we have already done? While not presented as a coordinated package, fiscal deficits have risen sharply in a number of countries and have, to a very significant degree, been financed by expanding the balance sheet of the central bank. It is perhaps significant that the various central banks have used unconventional monetary instruments in quite different ways, indicating that there is no consensus on the best way to do it. Regardless, the bottom line is that the increased supply of base money has been matched by an increase in the demand for bank reserves and the broader monetary aggregates have responded little, if at all. How might a more coordinated fiscal-monetary package have led (or lead) to a different outcome?

Those supporting OMF suggest that the essential difference between what has been done, and what they suggest, is that the infusion of base money will be described as “permanent”. What is not clear is how this “permanence” might alter the transmission mechanism, not least by overcoming the increased demand for cash reserves in any reasonable time period. One possibility is that, absent an increase in debt, there will be less of a tendency for sovereign rates to rise due to fears about sustainability. Conversely, is there not also the possibility that increased deficits, financed by monetary expansion, might lead to higher inflationary expectations and higher sovereign bond yields? I think this is possible and return to it below.

A final point concerning permanence is whether the monetary authority can credibly commit to such “permanence”. Central banks have repeatedly changed both their objectives and their preferred analytical models over the last 30 years. Moreover, they are in the process of doing so again. Astonishingly, they seem increasingly to be targeting real variables, as in the 1960’s and prior to the insights of Friedman and Phelps. Who then would believe them when they said “Trust me, it’s permanent”?

Another area where I am unclear has to do with the role of inflation and changes in inflationary expectations. For example, in his Cass Lecture, Lord Turner presents a traditional model in which inflation is driven essentially by the output “gap” and “independent” expectations. In the present juncture, this would likely imply that inflation was not likely to get out of hand any time soon. Yet, a large and permanent addition to the stock of base money would seem to have clear inflationary implications over the longer term. Indeed, a number of people (Abenomics?) would actually seem to welcome such an outcome since, assuming nominal interest rates can be held down, it would serve to reduce the real burden of sovereign debt. Evidently, the threat of an inflationary outcome would be increased by worries about fiscal dominance, which would likely be exacerbated by plans of OMF. Were there to be a related shift downward in the demand for base money, and a shift downward in the demand for broader monetary aggregates, this inflationary process could proceed very rapidly. Indeed, we have seen it happen many times over the course of the years, not least in Latin America.

Which brings me to a last puzzle. If it is at least possible that inflation could become a problem, does this not imply that the “apparently permanent” increase in base money might have to be reduced or offset by the use of macroprudential or other non traditional instruments? The first alternative raises the possibility that the original monetary infusion was both permanent and temporary. Like Schrodinger’s cat, it is both alive and dead which is not easy to understand. As for macroprudential measures, our knowledge of how well they work is in its infancy. It would be a big gamble to put too much faith in them to offset a monetary induced wave of inflation, to say nothing of all the other imbalances that might naturally arise in such circumstances.

My comments thus far might seem to indicate I am rather pessimistic about getting out of this “mess”. That is not quite right. I am just concerned about an over reliance on macroeconomic stimulus to do so, fearing that it might do more harm than good. Rather, I would use a blend of policies, chosen to reflect the special difficulties posed in trying to exit from a credit driven recession. They would have both demand and supply side elements, to respect the spirit of both Keynes and Hayek. I am, however, under no illusions when it comes to the political acceptability of some (all?) of these suggestions.

First, we need much more international cooperation on macro stimulus. Those countries in the best position to stimulate demand , should do so. Countries with large current account surpluses have more room for maneuver than others. Nominal exchange rate changes, where possible, must be accepted as part of the process of adjustment.

Second, we need more public and private investment. For the former, markets must be convinced that any increase in government liabilities comes with an associated increase in a productive asset. For the latter, we must try to create a more business friendly environment, not least with some of the uncertainties removed about the incidence of future tax burdens.

Third, we need explicit debt reduction on the part of ultimate borrowers, probably recapitalization (or closure) of the banks that lent to them, and in some cases international support for sovereigns who have themselves become over extended. Where sovereigns do have some room to increase debt, the case for using this room to stabilize the banking system (rather than direct spending or tax cuts) should be strongly considered (as suggested by my previous colleague, Claudio Borio, in BIS Working Paper 395).

Fourth, we need structural reforms to raise the potential for growth and to reduce the burden of debt service. As chairman of the EDRC at the OECD, I suggest that there are many “low hanging fruit” just waiting to be picked.

Crisis Prevention: The need for a new mindset

When the next credit cycle begins to emerge, we need to use policy instruments to “lean against the wind”. Even if all excesses cannot be avoided, by using tighter policies to constrain the amplitude of the boom we will also constrain the amplitude of the bust. Further, there will be more room to ease policies if they have been previously tightened. While there is a lively debate on how this “leaning” might be done, I would suggest the joint use of monetary and macroprudential instruments. Each has advantages and shortcomings, likely with a different balance in different countries, which makes the use of some combination of instruments seem more plausible. As I said above, we are in unchartered territory here.

As for the Simons/Friedman proposals, they come down to a rule for the rate of growth of the money stock with the objective of “ensuring” price stability. The problem with this assertion is that it depends on the assumption of a stable demand function for money (the “V” in MV=PT), which experience shows is far from being the case. As Gerry Bouey, my old boss at the Bank of Canada put it, after we gave up our monetarist experiment of the late 1970’s, “We didn’t abandon the monetary aggregates, they abandoned us”. Moreover with the spectacular increase in the size of the shadow banking system, I suspect the problem of monetary instability has become even worse in recent decades.

I would finally make a broader point. During the whole post War period, we have tended to follow highly activist macroeconomic policies (first fiscal and then monetary) with that activism much more apparent in resisting downturns than upturns. In short, we have followed a highly asymmetric set of macroeconomic policies which have both encouraged and rewarded imprudent behavior. Moreover, the upshot of this asymmetry has been a gradual ratcheting down of policy rates to essentially zero, and a gradual ratcheting up of government debt to levels that look increasingly unsustainable. In effect, these policies not only helped create the current crisis, but removed our capacity to deal with it using macroeconomic instruments. We have shot ourselves in the foot.

To avoid big crises in the future, we must become more willing to accept minor downturns, mini crises, and the occasional failure of financial institutions. No financial institution should be too big to fail. Again, I am under no illusions as to how politically acceptable this might be in a world dominated by “short term“ objectives, the popular belief that “something must be done”, and ample funding from lobbyists to fight meaningful reforms. Nevertheless, I continue to believe that this approach provides the surest means of fighting the accumulation of moral hazard and bad behavior that has led us to our current and still precarious situation.

William White, a former deputy governor of the Bank of Canada, and a former head of the Monetary and Economic Department of the Bank for International Settlements, is Chairman of the Economic and Development Review Committee at the OECD.

"Had the proposed regime change been in place, an economic downturn requiring an expanded government deficit and a rising monetary base would have been preceded by an expansionary period of declining deficits and a falling monetary base. Since this was clearly not the case in recent years, I suggest that both Simons and Friedman would have seen more risks than promise in OMF at this juncture."

The author seems to suggest that when the Chicago plan was proposed, there was not a fractional reserve system established in the US. Obviously, this cannot be the case for a plan to abolish fractional reserve banking. Said otherwise, what the Chicago plan proposed and Friedman endorsed later, never had a precedent of a full-reserve system. This argument makes no sense.

Bill White’s commentary responds to my argument, set out in a lecture at Cass Business School, that overt monetary finance (OMF) of increased fiscal deficits should not be a taboo policy option. My purpose was not to recommend specific policy actions in particular countries, but to widen the scope of debate about our policy response to the still profound challenges facing the advanced economies. White’s response is immensely valuable, engaging in detail with the arguments, rather than simply recoiling from the unmentionable.

There is a huge amount in White’s analysis with which I agree. As he stresses, the most fundamental driver of financial instability is the ability of fractional reserve banks (and shadow banking systems) to create credit and money, and thus to inject additional spending power into the economy. That capacity, described by Knut Wicksell in Interest and Prices, can sometimes support useful reflation; at other times, it can produce harmful inflation; at still others, harmful post-crisis deflation may result, as credit and money are destroyed. It can drive the real over-investment cycles feared by Austrian-school economists like Ludwig von Mises and Friedrich Hayek, and can drive harmful booms and busts in prices of existing assets, as described by Hyman Minsky.

The importance of these credit-cycle effects has increased greatly over the last 50 years, as the scale, complexity, and global interconnectedness of credit and maturity transformation processes has relentlessly increased. But, oddly and dangerously, their importance has largely been written out of modern macroeconomics, which has treated money as a neutral veil and paid little attention to the details of the credit and money-creation process.

White and I agree that the fundamental driver of the 2007-08 financial crisis was a huge increase in leverage throughout the economy. This “supercycle,” as White (quoting George Soros) calls it, was enabled, facilitated, and accentuated by Greenspan “puts” and financial liberalization. And it was viewed as benign by central banks convinced that the attainment of price stability was sufficient to ensure a lasting “ Great Moderation” of economic volatility .

As White describes, as the relationship between money supply and price levels deteriorated in the 1980’s, central banks came to assume that credit and money aggregates were of no particular interest. But, given the potential consequences for financial stability and the real economy, the size of financial institutions’ balance sheets relative to GDP matters greatly, quite independent of any price-level implications.

Indeed, there is a growing body of persuasive evidence (for example, recent work by Alan Taylor and Moritz Schularick) that the aggregate level of leverage in the real economy – private sector as much as public – is a crucial macroeconomic variable. Above some level of leverage, additional debt increases macroeconomic vulnerability to financial crisis and post-crisis deleveraging.

On all of this, White and I agree. We also agree on the need for a radical change to the financial-policy regime to promote stability and reduce the risk of future crises But, while White raises valid issues concerning the separate issue of how to respond to the post-crisis mess of debt overhang, deleveraging, and deflationary pressures, he does not undermine my case for considering the option of using OMF to fund increased fiscal deficits.

One radical regime change, proposed in the 1930’s by economists like Irving Fisher and Henry Simons, and endorsed by Milton Friedman in 1948, would be to abolish fractional reserve banking (and thus banks’ ability to create new credit, money, and purchasing power autonomously). I am not convinced that this is a realistic option. It overlooks the potential benefits of some maturity transformation, and it ignores the practical enforcement challenge – the potential for bank-like credit and money creation to flourish outside the formal banking system.

But the devotees of 100% reserve banking usefully focus our attention on the fundamental issue – the credit cycle – and, like White, I believe that fundamental change is required to ensure a more stable future system. This should entail the application of powerful macro-prudential tools: higher and countercyclical capital requirements, quantitative reserve requirements, and direct controls on borrowing through loan-to-value or loan-to-income limits. But, as White suggests, it also requires the integration of these macro-prudential tools with monetary policy operating through the interest rate, so that the two together lean aggressively against the upswing of the credit cycle. As White puts it, we need an entire new policy mindset, based on the recognition that financial structure, dynamics, and quantities matter crucially for macroeconomic stability, regardless of whether price stability has been achieved.

While building a better future financial regime, however, we must also deal with the severe problems caused by our past failures. Too much debt in the system means that our traditional policy responses – fiscal or monetary – may prove ineffective or produce harmful side effects.

The automatic and discretionary fiscal relaxations of 2009 played a vital role in offsetting falling private sector demand and attempted deleveraging. But if deficits are funded by interest-bearing debt, leverage simply shifts from the private to the public sector, raising questions about long-term public-debt sustainability. White quotes an OECD study arguing that Japan, the United Kingdom, and the United States may face problems in stabilizing their public debt ratios. In Japan’s case, I would go further: I can see no credible path by which Japanese government debt can be repaid in the normal sense of that word, rather than being restructured or monetized.

An alternative way to provide stimulus is via ultra-easy monetary policies – sustained low interest rates or unconventional measures such as quantitative easing. Absent alternative options, ultra-easy monetary policy has helped to mitigate the depth of the post-crisis recession.

But White and I share deep concerns about its long-term effects. Financial speculation and complex risky innovation may prove far more responsive than real economic activity to low interest rates. And ultra-easy monetary policy will work only if it stimulates increases in private leverage – the very problem that got us into this mess in the first place.

We seem, therefore, to have reached an impasse. We are in a mess created by deficiencies in our past regime, and the authorities seem to be out of fiscal and monetary ammunition. My Cass lecture argued, however, that in a fiat money system, the authorities never run out of ammunition with which to stimulate nominal demand. Using OMF to fund increased fiscal deficits is always an available option, and, in extreme circumstances, it should be deployed.

White does not directly reject this option. Instead, he poses useful questions and challenges to stimulate further debate. Quite rightly, he starts with the same fundamental question I posed in my Cass lecture: Do we need more stimulative policies of any sort to engender a faster rate of nominal GDP growth than is currently being achieved? In some countries, the answer might be no. As I argued in my Cass lecture, the disappointing division of UK nominal GDP growth between inflation and real output over the last five years casts doubt on whether more stimulus is the most appropriate policy. Indeed, my purpose was not to argue that OMF must be deployed in all countries today, but simply to make the case for its availability as a tool to be used if and when conditions are appropriate.

That said, across the major advanced economies – Japan, the eurozone, the UK, and the US – nominal GDP growth rates over the last five years have been well below those compatible with low inflation and attainable real output growth. More rapid nominal GDP growth would almost certainly have resulted in higher real growth and would have made it easier to achieve necessary deleveraging. White argues that demand stimulus can impede deleveraging (presumably because ultra-low interest rates create an incentive for banks to forebear and roll over debts, rather than to restructure them and write them off). But the experience of Japan over the last 20 years shows that without moderately positive nominal GDP growth, aggregate leverage (private and public combined) tends to increase relentlessly.

White’s second challenge is to ask how different from current policy OMF really is. After all, countries are running large fiscal deficits and central banks have bought government debt, expanding the monetary base. Doesn’t that amount to a sort of potential OMF without admitting as much?

I take the point; in fact, my Cass lecture explored the close potential equivalence between apparently different policies. But I would still argue that different policy choices would result if the option of OMF were openly considered.

Consider two scenarios. In the first, the government runs a fiscal deficit of 5% of GDP, funded with the issue of interest-bearing debt, and the central bank conducts quantitative-easing operations equal to 5% of GDP, while stating that these operations will in future be reversed. In the second scenario, the government runs a fiscal deficit of 10% of GDP, of which 5% is overtly financed with central-bank money, and the authorities make an explicit commitment that this increase will be permanent. As a result, the additional 5% deficit does not increase measures of government debt as a percentage of GDP.

In terms of the initial impact on the monetary base, the policies would be the same – an increase equal to 5% of GDP. But, in terms of the immediate impact on nominal GDP, they would almost certainly be significantly different. The latter option would, to use Milton Friedman’s phrase, inject additional demand directly “into the income stream,” rather than trying to stimulate the economy through the indirect levers of asset-price and portfolio-balance effects.

Thus, while White rightly points out that existing policies to increase the monetary base have elicited little or no response from broader monetary aggregates, this in no way undermines the argument for OMF. The case for OMF does not rely on any assumed mechanical relationship between the monetary base, the money supply, and nominal GDP. Indeed, it rests quite explicitly on the belief that in some circumstances increases in the monetary base per se will be wholly ineffective in stimulating nominal demand because of liquidity-trap effects.

In a lecture in October 2012, Mervyn King, the former governor of the Bank of England, urged proponents of OMF to be clear that they are proposing increased fiscal deficits. He was quite right. OMF is a policy designed to enable a larger fiscal deficit while avoiding the crowding out, Ricardian equivalence, or long-term debt-sustainability constraints and offsets that can limit the effectiveness or desirability of debt-funded fiscal stimulus.

A crucial feature of OMF, therefore, is that it results in a permanent increase in the monetary base. As White suggests, this raises a third question: whether the commitment to permanence can be made credible. And he is right that no central-bank commitment to any future policy carries absolute certainty. The stated current intention of all major central banks is that quantitative easing or similar operations will be reversed. But it is quite possible that they will prove permanent, and that central banks’ balance sheets, even if they cease to increase, will remain permanently larger than they were before the crisis.

That, after all, is what happened after the Federal Reserve-Treasury accord of 1951: the Fed ceased buying new Treasury bonds, abandoning its commitment to keep bond yields at 2.5%, but it never reversed its balance-sheet expansion. Conversely, authorities who announce that they have “permanently” increased the monetary base via OMF could in future reverse this “permanent” increase by running fiscal surpluses and withdrawing money from circulation if the stimulus turned out to be greater than appropriate. This was precisely the symmetric policy framework that Friedman advocated in 1948.

But, while absolute pre-commitment is not possible, clearly stated intent still almost certainly matters. The clearly stated intent behind quantitative easing is that the operations will be reversed, and that any increase in government debt, even if currently held on the central bank’s balance sheet, will create a future debt burden for households and companies. The overt commitment to reversal thus logically invites a Ricardian-equivalent offset to the stimulative effect of current fiscal deficits. By contrast, a clearly stated intent that a portion of the fiscal deficit will be permanently financed by money creation, unless and until the stimulative effect is higher than originally anticipated and desired, would have a different effect.

Where I agree completely with White, however, is that OMF would require the potential future application of macro-prudential tools to offset unintentionally strong stimulative effects. OMF enables a fiscal stimulus that is financed by an increase in the monetary base. When introduced in an environment of private-sector deleveraging, it is unlikely that the first-order stimulative effect will be immediately multiplied by private credit and money creation. But, in a world of fractional reserve banks, there is clearly a danger that the initial stimulus could be multiplied later by the subsequent expansion of private “inside money” purchasing power, as animal spirits return to bank and shadow-bank lenders and borrowers.

As a result, the necessary and logical corollary of the application of OMF is the restoration of quantitative reserve requirements to the policy toolkit. Applying such requirements would not reverse the increase in the monetary base, but it would constrain its stimulative effect to the originally intended level.

This suggests, of course, that while it is essential to consider separately the distinct issues of the future financial regime and the post-crisis response, there are links between them. Indeed, those links were central to the arguments advanced by economists like Simons, Fisher, and Friedman, who, surveying the wreckage produced by excessive credit creation in the 1920’s, proposed both OMF of fiscal deficits and a system of 100% reserve banking.

In such a system, the danger that an initial OMF stimulus will be multiplied by subsequent credit and private money creation disappears, because the monetary base is the money supply. In a fiat-money world without fractional reserve banks, OMF is an obvious strategy: indeed, without it, positive nominal GDP growth might be difficult to achieve, and optimal real growth might therefore require an unattainable downward flexibility in nominal wages and prices.

Simons, Fisher, and Friedman’s support for both OMF and 100% reserve banking therefore formed an internally consistent policy package. White questions, however, whether their support for this package was not fundamentally focused on the 100% reserve regime, rather than on OMF as a post-crisis response. As far as Simons is concerned, I think he has a reasonable point. But Fisher quite explicitly identified the absence of interest payments on deficits financed by permanent monetary expansion as one of the benefits of 100% reserve banking and OMF. And Friedman set out in 1948 a very clear case for using OMF to stimulate an economy when appropriate: “another reason sometimes given for issuing interest-bearing securities is that in a period of unemployment it is less deflationary to issue securities than to levy taxes. This is true. But it is still less deflationary to issue money.”

Despite White’s thoughtful questions and challenges, therefore, I remain convinced that there are some circumstances in which OMF would be an optimal policy, and that we should be willing to weigh the pros and cons of its application calmly in the light of evolving post-crisis circumstances, rather than to treat it as a taboo option. Applying it would, of course, entail difficult calibration issues. Its effect would be difficult to predict, with a very real danger of overshooting. The need for offsetting macro-prudential tools is clear.

Using OMF would take us into uncharted waters. But, as White says, we are already there, whether we like it or not. That is the inevitable consequence of our poorly designed pre-crisis financial regime.

And yet it is not clear that White, sharing my concerns about the impact of funded fiscal deficits or of ultra-easy monetary policy, has convincing alternative proposals that could return us to shore. Rather, his specific policy proposals might be most effectively pursued if combined with OMF. For example, I agree with White’s argument for “more public and private investment.” If more nominal demand is desirable, it would make sense to skew it toward investment, not consumption. But more public investment financed with public debt may threaten future debt sustainability: and it is unclear that ultra-easy monetary policy is effective in stimulating real private investment. Public investment financed by OMF might be an option.

Similarly, White quotes Claudio Borio on the possible use of public debt to stabilize the banking system. But if we commit to recapitalize banks with debt-financed fiscal expenditure, we may simply shift solvency concerns from banks to sovereigns, reinforcing one of the most pernicious dynamics in the evolution of the eurozone crisis. An alternative approach might be to use a one-off dose of OMF to finance a significant bank recapitalization, shifting as rapidly as possible to a new, more stable financial regime. Such a policy might assuage the fear – which White does not mention but that for many is the central argument against OMF – that once the taboo is broken, political pressures will lead inevitably to harmful overuse of OMF.

As I argued in my Cass lecture, OMF is like a very powerful medicine, potentially valuable if taken in appropriate quantities in specific circumstances, but potentially fatal if taken in excess or when stimulus is not required. Maybe it is so dangerous that we should eschew its potential use. But we should at least debate the issue, and face clearly the limitations and potential adverse side effects of alternative policies.

White’s response to my lecture engages constructively with that debate, and focuses our attention on the distinct but nonetheless linked issues of the appropriate future financial regime and the best post-crisis response. My own judgement is that we have not yet been radical enough in our redesign of the regime, and that the problems of debt overhang and deleveraging, resulting from our deficient pre-crisis regime, remain so profound that all available response options need to be carefully considered.